It's a truly bullish way to wrap up the week. China has reported a 7.9% rise second in quarter GDP, driven mostly by a 15% surge in June consumption and a huge boom in bank lending and government stimulus. Aussie stocks felt the warm glow and rallied just below 4,000 on the ASX/200 yesterday. Aussie stocks are now up nearly 7% for the week.

But the even better news from the bullish camp is that perma-bear Nouriel Roubini has defected! Yes, Roubini told a conference that the "free fall" in financial losses is over and the U.S. may exit its recession by the end of the year. This was enough sweet talk to send the Dow up nearly one percent.

And then there was an upgrade to second half U.S. GDP forecasts from the U.S. Federal Reserve. In April, the Fed said second half U.S. GDP would shrink by 1.3% to 2.0%. The revised forecast released yesterday now says U.S. GDP will only shrink by 1.0% to 1.5%. A stunning upgrade!

The Fed's revised projections also show that the U.S. economy will grow faster than it first thought in 2010, once the much-anticipated recovery takes hold. In April the Fed thought the U.S. would grow by 2.0% to 3%. But in the revised forecast now says the growth rate should soar from 2.1% to 3.3%. A stunning upgrade!

The only negative note in the Fed's forecast is that it reckons U.S. unemployment will keep growing to over 10%. That, presumably, is a drag on the economy. But if credit conditions improve, maybe all the people who've lost jobs because the U.S. economy is not producing and not competitive can, you know, get a credit card and live off of that.

But putting on our serious face, and while we are giving valuable publishing space to the optimists, we should point out that some people think the worst case scenario for the U.S. Housing market is already priced in to financial stocks. This leaves said stocks all clear to lead the market higher, along with tech, resources, bonds, and cash!

For example, Jim Cramer reckons that if you assume a 50% total write-off rate on the 14 million mortgages written between 2005 and 2007 in the U.S., you are only talking US$1.4 trillion in losses (7 million homes X $200,000 per home. ) Cramer says the banks have already written off that amount and that the banks stocks are priced for a worst-case scenario that may not materialise.

And if it doesn't, it would lead to a faster recovery in bank balance sheets, which in turn would lead to a recovery in bank lending, which would not lead to inflation because the Fed has a plan to remove liquidity from the system and everything thing will be fine!

And you thought Neverland was a ranch in California.

Whether Cramer is right depends on which vintage of mortgages have accounted for the losses in the financial sector so far and which are still going bad. The chart below from the Cleveland branch of the Federal Reserve suggests to us that there are more losses to come than have been accounted for. Why do we say that? First the chart...

What does the chart tell us? Well, it shows that in 2003 and 2004, Fannie Mae and Freddie Mac led the surge into subprime lending. This is the vintage of loans that went bad in the last year as interest rates moved up and house prices moved down, putting many new buyers and speculators underwater. This is where the first $1.4 trillion in losses came from.

But the real issue is the quality and quantity of mortgages that were packaged up and securitised from 2005 to 2007. As the GSE's reduced their originations, banks stepped in-often haven acquired non-traditional lenders for just this purpose-to keep feeding the boom. The banks wrote the loans and sold them to either other, purchasing default insurance on the securitised loans from AIG.

These loans are not subprime but supposedly higher credit quality Option ARM and Alt-A loans. And these are the loans the banks, we'd suggest, are carrying at elevated values. We'd also suggest the banks are not adequately capitalised to realise losses on these loans should the housing market get swamped again by another wave of defaults and foreclosures. This is where the second $1.4 trillion in losses will come from.

But of course it's wacky to suggest all that. We might as well say that aliens crashed at Roswell and that the moon landing was faked (it probably was). There's just no way it could get any worse than it did in 2007. Could it?

We'll take up that question next week. And we'll also take up the China question. While all the focus is on the cloak-and-dagger between Rio Tinto and Beijing, another Aussie industry may already be rising to replace iron ore as Australia's most valuable export commodity. Stay tuned for details.

In the meantime, some reader mail for the weekend....

Hi Dan,

Rose

--Attn: Dan Denning

Trevor B.

--Hello Dan,

Victor B.

You should always be careful of everything you read Victor. It's a good idea! As for the criticisms in the piece of the gold standard, they miss the point entirely. The main criticisms are that the gold standard did not give governments enough flexibility to borrow money to pay for wars or spend their way out recessions. The standard was abandoned because of the fiscal discipline it imposed on nations.

We'd argue that the European nations chose to squander their accumulated capital on destroying each other. The gold flowed to the U.S. as a result. That's the price you may for redirecting economic production in the service of the Warfare/Welfare state. There is no scenario in which you can escape the long-term consequences of how you divert production away from creation and toward destruction.

It doesn't bother us at all to be in the fringe. It's cool here (shaded). The company is eclectic and interesting. And most of the people we know here don't confuse causes with effects. The fiat money standard leads to a permanent welfare state because the government can tax to pay interest on its borrowings.

This makes its borrowings theoretically unlimited, which is why governments relentlessly expand their intrusion into commercial and private life, nosing around to get in the way, boss people around, and clip tickets to pay for bloated bureaucracies.

A gold standard is an impartial negative feedback loop. If an economy produces and sells, it accumulates capital and attracts investment too. If it borrows, spends, and consumes, it does not accumulate capital. It accumulates debts and the ownership of its gold and its assets its gradually transferred to creditors.

A version of that is happening today anyway, with creditor nations holding the whip hand over debtors. Only the illusion that fiat money is worth something and that governments can actively manage the economy prevent people from realising a money and power migration is happening, and the English-speaking nations are not on the winning end of it. Australia is, of course, an English-speaking nation. But it's also a resource rich land not far from China and India, where the demand of the future is coming from. It's the country's saving grace.

Meanwhile, we believe the huge increase in liabilities coming from the Western world will inevitably lead to either devaluation of those currencies or the preferred method of reducing huge outstanding debts, money printing. This is going to be very good for gold, no matter what a few economists in the mainstream may say.

Dan Denning
for The Daily Reckoning Australia

• Is Kevin Rudd Planning to Steal Your Superannuation and Bankrupt Your Retirement?
• World of Super Collides With World of Credit Crunch
• How Did Australia Get Caught Up Losing Money in Commercial U.S. Real Estate?
• Self Managed Superannuation Funds on the Rise
• Your Average Australian Super Fund

It was a throwback kind of day in New York, with Intel up over 7% on better-than-expected earnings figures and a positive outlook on PC demand. In fact the S&P 500 is up over 6.1% for the week. If Aussie stocks conform to the pattern, they should close the day up around the same amount for the last four days.

First Goldman leads a rally. Then Intel. It's like a parade of credit bubbles being inducted in the credit bubble hall of fame. Enjoy the spectacle it for as long as it lasts. But be wary.

Yesterday we gave incoming IFSA boss John Brogden a serve for advocating an increase in mandatory super from 9% to 12%. In fairness, we should point that IFSA has released a new charter (not yet approved by member) that would phase out inbuilt commissions on managed funds starting in July of 2010. That's a good start in realigning the interests of your super fund with your own financial interest.

But we're still not convinced it solves the problem of creating a reliable retirement income from your actively managed funds. Brogden told the Australian Financial Review that, "Increasing the superannuation guarantee levy is strong on the agenda; we're very clear that we need to boost retirement incomes."

Though Kris Sayce is the Old Hat Factory's resident expert on super, as far as we can tell, the "superannuation guarantee levy" merely guarantees that 9% of your wages are confiscated before you get a chance to even touch, smell, or taste them.

Of course everyone is told that super is an addition to base salary. But in actual fact, it makes up part of your total compensation. And as such, we'd suggest that the current system effectively prevents you from using this money the way you see fit. It denies you control of your own property, presumably because you are too stupid to look out for your own interests.

Can funds really look out for your interest? Well, even though, as we pointed out last week, actively managed funds, ON AVERAGE, underperform the market, there are some fund managers that DO beat the market. And they are worth paying attention to, not so much because you want to buy the funds. This is a common mistake. Last year's best funds are almost statistically destined to underperform this year's winners.

No. The main reason you want to study the actively managed funds is to see what's working and see if you can imitate it, or find something worth imitating. For example, the best-performing long-only share fund of the last 12 months is Tim Samway's Hyperion Australian Growth Fund.

"The key to outperforming in an economic downturn is to buy stocks that generate cash flows independent of consumer spending," Samway told the AFR. "We buy stocks that produce organic growth by rolling out a business model, rather than relying on the consumer to come back," he added. Sounds pretty sensible in a Great Recession, doesn't it?

More importantly, cash flow is something you can measure. You don't have to guess. And-as the inaugural issue of Kris Sayce's new Australian Wealth Gameplan shows, there are some Australian industries that continue to generate healthy cash flows no matter what the rest of the economy does. For income-minded investors, buying these stocks at bargain prices is the closest thing you'll get to a second income from the stock market.

The only real weakness to Hyperion's case is that it's a long-only stock fund trying to make hay during a bear market. Thus, even though it's the best performing fund of the last twelve months, it's down one percent. In relative terms, that's great. In absolute terms, it's down one percent.

This highlights a basic problem with just having your money unceremoniously dumped into super funds that are overweight equities or placed with long-only fund managers who HAVE to be in the market. This kind of asset allocation (biased toward stocks) doesn't really take advantage of the options that super makes available.

But you'd only know of those options -and exercise them-if you were actively seeking the best way to manage your entire portfolio of assets, in order to generate both income and safety. These are the questions Kris is taking up with a handful of various experts from around Australia in his new publication. You can't buy it just yet. But stay tuned next week for more news.

Incidentally, the best way to generate a second income is probably to own your own business. That's also-in our opinion-the most likely way to build wealth.

One way to NOT build wealth is to borrow. And as you know, Australia is set to borrow up to $300 billion in the next few years to finance its growing deficits. Some think this is the proper role of government. Others think it is madness. But one non-political question is whether the government will actually be able to borrow that money at all.

An article in Wednesday's AFR raised the possibility that an Australian government bond auction could fail this year. The auctions are being conducted on an almost weekly basis by the Australian Office of Financial Management (AOFM). "The poor performance of two bond auction tenders in mid-June has cast a shadow over the AOFM's issuance program and prompted speculation that an auction may fail in the next year."

Before we get to what the consequences of a failed bond auction might be, let's look at the data we compiled from the AOFM site. We've compiled the results from the last nine auctions, dating back to June 3rd. By the way, there's another one tomorrow! Included are the date, the amount raised, the average yield, the maturity date of the offering, and the coverage ratio.

By the way, the coverage ratio is important because it shows you the appetite for government debt. The AOFM defines the coverage ratio as, "The ratio of the total amount of bids received to the amount on offer at a tender for the issue of Commonwealth Government Securities. Also referred to as the bid-to-cover ratio." Let's take a quick look at the data and then what it might mean for investors.

Click to enlarge

So what does all that mean? Well quite a bit actually!

The main point is that the coverage ratio dipped below two twice in June. This directly affects the ability of the Federal government to finance its deficits. If buyers dry up-for whatever reason-we imagine either the auction would fail, OR, the Reserve Bank would have to step in, Fed style, with some direct purchases of government securities.

This shows that quantitative easing-the kind of thing that weakens a currency by increasing the money supply-is not so far-fetched in Australia as you might think. Granted, Aussie public deficits and debt are modest compared to countries like the U.S. and U.K. But while it's a huge exporter of natural resources, Australia is a huge importer of capital. And that puts government finances in a vulnerable position if the bond auctions are not supported by domestic and foreign buyers.

The more debt the Federal government puts on auction, the more pressure it puts on the Big Four banks to snap it up. But that may not happen according to plan. "Of particular concern," reports Katja Buhrer in the AFR, "is the suggestion that banks-keen buyers of commonwealth bonds to exploit an arbitrage opportunity in bond markets-are artificially propping up demand."

It's been argued that there will be plenty of domestic buyers for government debt. But according to Buhrer, "Demand from local fund managers for commonwealth debt has been lacklustre, with fund managers preferring to snap up insured state-government debt which offers higher yields. [Ironically the state government debt was guaranteed by the Federal government, which now appears to be driving up costs of Federal borrowing].

There doesn't appear to be much rhyme or reason to the maturities offered by the AOFM. And to the extent that the AOFM has to compete with the States or corporations on shorter-maturity bonds and notes, it means interest rates will go higher (it will cost more to borrow). On the other hand, the AOFM could offer longer-dated bonds and notes. But as you can see from the table, the longer you take to pay back principal, the higher interest rate creditors typically demand.

But aside from the upward pressure on interest rates that government borrowing seems bound to produce, the big issue is who Australia's creditors are going to be. Will it be Aussie banks? Or, in a country that's traditionally an importer of capital, will it be off-shore creditors? And will those creditors be friendly?

With a US$1 trillion annual deficit (the first time ever) we know the U.S. government is not likely to be a creditor. It's a chronic debtor. On the other hand, there's this little country up the north that now has over US$2 trillion in foreign exchange reserves it wants to invest.

True, this tiny country has had trouble investing that money in Australian resource companies via equity recently. And that's caused a few problems here and there. But when you generate a capital surplus by producing things and selling them instead of consuming things with borrowed money, you have to put that surplus capital to work somewhere, don't you?

If Australia is looking for a creditor to guarantee its bond auctions don't fail, it ought to look no further than China. But the relationship is a bit complicated at the moment. And we wonder what the Australian government and the Reserve Bank would do if faced with the choice of borrowing from China or printing more money to support demand at Australia's growing number of bond auctions.

Hello rock. Meet hard place.

Dan Denning
for The Daily Reckoning Australia

• How Did Australia Get Caught Up Losing Money in Commercial U.S. Real Estate?
• Is Kevin Rudd Planning to Steal Your Superannuation and Bankrupt Your Retirement?
• Roubini Says Recession Will Continue Through End of Year
• Choking on Debt in the Unfolding Anglo-Saxon Bond Crisis
• Your Average Australian Super Fund

Talk about getting on the front foot. Actively managed funds have not exactly had a stellar few years. And as we reported last week, there's some doubt as to whether the funds, on average, can ever actually beat the market. Increasing compulsory contributions might be a way to make up for revenue you'll miss out on as those that can choose to move to self-managed funds.

Frankly, though, the whole idea of not having a choice about super reminds us of the ant colony in T.H. White's "The Once and Future King." In the ant colony, there is very little choice. Everyone has a role defined for him and even language itself is limited. The smaller the vocabulary you have, the more difficult it is for you to articulate your dissent.

The rule of the ant colony is that "everything not compulsory is forbidden." How much does that sound like the Nanny state we are living in? The government is not only intent on telling you what you cannot do (smoke, drink, eat like a pig) but what you must do under penalty of law (surrender your income to be managed by someone whose financial interests are not aligned with yours.)

We're not saying that laying up savings for a rainy day isn't a good idea. It's a great idea. In fact, it's so important, we'd suggest it's not the sort of decision you should surrender to anyone else. Preparing for your financial future is ultimately your responsibility because you're the one that's going to live that future, not your fund manager. If you don't have your own wealth game plan, odds are you're going to lose the game.

What that game plan includes depends on your appetite for your risk, and, of course, your view on the markets and your investment time frame. But these are not complex issues beyond the capability of ordinary people to discuss and plan for. They are the sort of things we should all specialise in if we want to make, grow, and keep our money-money that plays a part in whatever kind of life we choose to live.

If we're a bit philosophical today it's because we're recovering from a weird ailment. Our colleagues call it the Darth Vader Diet. Last week we woke up to a constricted esophagus. It made it very hard to swallow. At first we thought it affected our breathing.

But once the panic subsided, we realised it was some sort of spasm in our esophagus, like a cramp making its way down our throat (it's just above our stomach at the moment). It's been dubbed "the Vader diet" because it's like Darth Vader is squishing our throat because he finds our lack of confidence in the stock market disturbing.

In any event, we've been forced to a mostly liquid or mushy food diet so nothing gets lodged in our throat while it's sill crook. It's a good weight loss method, despite the discomfort. And it makes for a clear-if somewhat whimsical head. Hopefully the antibiotics and donuts will kick in and fix things up soon. Until then...

Dan Denning
for The Daily Reckoning Australia

• Equity Asset Allocation and Portfolio Rebalancing Left Out of Superannuation Review
• Self Managed Superannuation Funds on the Rise
• Your Actively Managed Superannuation Fund Cannot Beat the Market
• The Advice to Never Touch Your 401(k) is Not So Cut-and-Dried
• Your Average Australian Super Fund